Session 1: What is "the Theory of the Firm"?

Question 1

Motivation problems

Answer 1

Feature conflicting or diverging interests between players in an organization. They often occur in situations where something must be divided. Example: Dividing a pie, one person gains while the other loses
* Firms solve cooperation problems by means of authority (direct orders) and performance incentives.
* Markets solve them by means of the incentives embodied in the price system (e.g., if you receive residual payments, you are incentivized to work hard).

Question 2

Co-ordination problems

Answer 2

Common or joint interests of the players. The issue is how to enlarge the pie for the players. It matters for the solution of these problems which approach, or theory is adopted
* Firms solve coordination problems by means of procedures, planning, culture, etc. (typically solved by managers).
* Markets solve them by means of price signals (based on supply and demand by incentivizing people through profitability).

Question 3

Optimal division of labor

Answer 3

Division of labor should be set at level, where the difference between the benefits of DOL and the costs of DOL is the largest.

Question 4

The idea of TOF

Answer 4

Situations of potential confusion (= lack of coordination) and conflict (= lack of the right motivation) can be turned into situations of cooperation by means of the right contracts, incentives, ownership arrangements

Question 5

COASE: The nature of the firm

Answer 5

• Firms are alternatives to markets.
• Authority is a mechanism for allocating resources.
• Whether firms or markets (make or buy) are used depends on transaction costs.

Question 6

COASE: Why do firms exist?

Answer 6

”…there is a cost of using the price mechanism”
* Discovering relevant prices (coordination).
* Negotiating and concluding a separate contract for each exchange(cooperation).

Question 7

COASE: Boundaries within a firm

Answer 7

There are increasing marginal costs of organizing in a firm.
* As companies grow, managers make more mistakes, e.g., because of loss of information (“hierarchical costs”)

Question 8

COASE: Optimal size of firm

Answer 8

Boundaries: Optimum size where the costs of organizing a transaction inside the firm = cost organizing it using the price mechanism (market)

(see picture in notes)